European bank shares led the fallers, hours ahead of crucial talks that will help determine whether Greece receives €8bn (£6.96bn) of funds it needs to stave off default.

In London, the FTSE 100 index closed down 109 points at 5259, or 2%. Wall Street was down nearly 200 points or 1.7% at 11309 in mid morning trading.

The sell-off followed a weekend meeting in Wroclaw, Poland, where EU countries failed to come up with a consensus on how to prevent a Greek default. European leaders clashed with US treasury secretary Timothy Geithner, who told them to stop "loose talk" that was damaging the eurozone and bringing "catastrophic risk" to global financial markets.

Michael Hewson, market analyst at CMC Markets, said: "The lack of any headway at the Ecofin weekend meeting in Poland, along with a swift dismissal of advice from Geithner, merely serves to highlight the simmering tensions among European politicians as they try to balance the competing demands of political unpopularity at home against the need to reassure financial markets."

Shares in French bank Société Générale tumbled more than 6% in Paris, making SocGen the biggest faller among European banks. In London, Royal Bank of Scotland, Barclays and Lloyds Banking Group all fell by more than 5%.

In Asia, markets were also bathed in red. While Japan's Nikkei was closed for a national holiday, Hong Kong's Hang Seng lost 2.4% and markets in Taiwan, Seoul, Singapore, Shanghai and Jakarta were down more than 1%.

The Greek government will continue its meeting after being told that the next tranche of the bailout, €8bn due at the end of the month, hinges on further belt-tightening.

"The timing of a Greek default remains in the hands of the troika and it is difficult to believe that they will decide to pull the plug at this stage because of the potential impact upon the other troubled sovereigns and the banking sector," said Gary Jenkins, head of fixed income at Evolution Securities.

"That said, who knows what contingency plans they have prepared behind closed doors (although the fact that they have leaked like a sieve throughout the crisis suggests we would have heard about them if they had …) and on the day that all the ducks are lined up then that might be the day that support for Greece is withdrawn. However, comments from the German finance minister that 'membership in a monetary union is an opportunity, but also a heavy burden … the Greeks must decide whether they want to bear this burden' might suggest that the endgame is nigh."

Elsewhere, credit ratings agency Moody's is expected to announce within a month whether it plans to downgrade Italy's Aa2 rating, a move that could escalate the European debt crisis, although Standard & Poor's already rates the country two notches lower at A+.